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January 7, 2014

Talking to Business Owners About Managing Their Wealth

Tocqueville Asset Management founder writes open letter to an Internet entrepreneur about why he should diversify out of company stock

Entrepreneurs with most of their wealth tied up in their businesses are probably close to the top of most financial advisors’ prospect target list.

Advisors know the lack of diversification puts their capital at risk and want to help manage their wealth. But how do they make the case?

It may help to understand the mentality of a business owner and to make clear distinctions between entrepreneurial thinking and long-term portfolio investing.

And that is a task that Francois Sicart, the founder and chairman of Tocqueville Asset Management, has helpfully undertaken in an open letter he wrote to a friend, a senior executive for 10 years at one of the most successful public companies in the Internet sphere.

The tech exec had a sudden epiphany and asked: “I suddenly realized that almost 90% of my personal fortune is in the shares of my company. Is this safe?”

Sicart frames the question as a “patrimonial” rather than “investing” question.

He concedes that the entrepreneur’s company shares likely have better prospects and more favorable valuations than other investments, but advises the entrepreneur to consider this a “life choice” rather than a mere stock market decision:

“Even if at some point in the future you decided to go into another venture, you would be at an age when one does not invest all of one’s capital in a single project. You will need a more diversified nest egg as a backstop – for your security and your family’s,” Sicart writes.

To overcome the psychological bias against diversification faced by entrepreneurs, Sicart recommends his friend do so incrementally:

“It is entirely possible that your diversified portfolio will underperform the shares of your high-flying company in the stock market for a period of time. And diversification may also bring with it some capital-gains taxes that might only have affected you later in your one-stock patrimony. You should be aware of those possibilities and become reconciled with them. They are for your greater, ultimate benefit.”

The Tocqueville chairman also warns his friend about the changed perspective of portfolio management, explaining that an entrepreneur can better handle the volatility of his own stock, with which he is intimately familiar: if its share price weakens, the entrepreneur can embrace the ebb as an attractive investment opportunity.

However, “once you own shares of companies where you are just an outside observer with no control over the fate of those shares, you will tend to fall prey to the insecurities that affect most investors,” and thus be tempted to sell.

That is one further reason why entrepreneurs should diversify incrementally, to “get accustomed to the normal, cyclical, and sometimes volatile behavior of a stock portfolio.”

Other differences in the entrepreneur’s mentality from that of an investor include decision possibilities. An investor can dump the stock of a company that has grown too expensive, whereas an entrepreneur’s only recourse may be to take over a cheaper company, with its attendant risks.

Entrepreneurs also prize merit where investors show a greater concern for price. But Sicart cites the example of Cisco in the late ’90s. Its reputation for quality was widely shared and its revenues, earnings and cash flows “either tripled or quadrupled since 1999. Nevertheless, anyone who bought the shares since then either lost or made very little money: After peaking at $80, the stock currently trades around $22.”

Similarly, companies that “change the world” may not make money, as Sicart demonstrates through the examples of RCA at the advent of radio and AOL at the beginning of the Internet era — just one final reason why his entrepreneur friend should begin his experiment “with a couple of good mutual funds or … [a] managed portfolio.”

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